The last two posts here were about CIFIA’s pre-execution rate collar, or limited buydown.  The posts considered several things:

• Limited buydowns are potentially important to carbon pipeline developers during the process of negotiating and finalizing rights-of-way and other contracts.  A rate collar will help stabilize the project’s financing economics at a time when many difficult time/money decisions are being made, well before construction starts.  To the extent that also helps accelerate pipeline development, it’s presumably at the core of CIFIA’s policy mission.

• If rates rise after a CIFIA application is accepted, the limited buydown feature will prove its value.  But in this situation, CIFIA may find it difficult to manage the impact of a large volume of limited buydowns on the program’s available discretionary appropriations.  Unlike post-execution rate locks, which automatically receive permanent indefinite budget authority, an in-the-money pre-execution rate collar will likely require an apportionment of CIFIA’s Congressional funding when the loan is executed.

• If rates fall, I think CIFIA can (and should) reset developers’ original applications to reflect the lower rates.  This is based on precedents from the WIFIA loan program, which has reset many post-execution rate locks.  The analogy is not exact for limited buydowns, but substantively very close.  The lower reset rates, however, will be prone to the budget issue noted above.

One general conclusion arises from all this:  If I’m correct that limited buydowns will be important both to pipeline developers (for project economics) and CIFIA (for fundamental policy outcomes), the program’s budget authority will be the limiting factor on offering this feature, unless rates become relatively stable, something that’s not likely to happen over the next few years.

An Arbitrary Limit

That kind of limiting factor on a useful interest rate management policy tool seems arbitrary.   Its origin is solely in FCRA’s distinction between what gets permanent indefinite authority (interest rate re-estimates on executed loans) and what does not (anything pre-execution).  That’s not based on any real-world factors in infrastructure investment.  WIFIA’s highly rated public water agencies certainly appreciate the post-execution rate lock because it avoids negative arbitrage cost if they’d had to escrow a muni bond issue instead.  But did they really need it?  Did it make any difference to their projects’ designs or timelines?  Yet WIFIA’s success was built on the ability to offer and then to enhance (by resets and expanding project definition to include long-term construction programs) free post-execution rate locks without worrying in the slightest about a discretionary budget impact.

In complete contrast, even if CIFIA pre-execution rate collars are critical to carbon pipeline development the program will likely need to worry about their discretionary budget impact, possibly to the point of rationing the feature under some circumstances.  This is true despite the lack of any substantive difference between a five-year post-execution rate lock and a three-year pre-execution collar followed by a two-year post-execution rate lock in terms of taxpayer cost.   As noted in a prior post, both simply amount to the federal government locking in an interest rate five years before the loans are funded.

Mitigating the Limiting Factor

FCRA law isn’t going to change anytime soon.  Still, there might be some scope to improve the budgetary treatment of those interest rate management tools that are useful to CIFIA and to future federal programs that might find themselves in the same situation.  The rest of this post outlines one approach that might be workable.

The key concept is what constitutes ‘execution’ in FCRA.  It’s apparently based on incurring an obligation, which makes sense in the context of a major theme in federal budgeting, anti-deficiency.  Here’s the language from Section 502 (2) of the FCRA statute:

The authority to incur new direct loan obligations…shall constitute new budget authority in an amount equal to the cost of the direct loan…

I think that’s black-and-white, both in language and in principle.  If a government agency incurs an obligation by executing a loan agreement, it’ll need authorized appropriations to cover the estimated cost at that point.  Cost here means the discounted present value of expected loan losses due to default but also Treasury’s economic funding loss if the loan’s interest rate is less than the relevant Treasury yield that day.  WIFIA’s loans are executed and re-executed with a current Treasury rate, so there’s no funding loss and no need for appropriations beyond the PV of expected defaults.  However, an in-the-money limited buydown will, by definition, result in an executed loan with a sub-Treasury rate and a funding loss.  Hence the problem.  I don’t think there’s any way around this part of the equation.

There’s more latitude in the definition of a ‘direct loan obligation’ in Section 504 (d)(1) of FCRA.  The definition needs to reflect an intrinsic reality of credit agreements, that there are always conditions the borrower must fulfill before the lender is obligated to write a check: 

The term “direct loan obligation” means a binding agreement by a Federal agency to make a direct loan when specified conditions are fulfilled by the borrower.

In a multi-billion-dollar project financing loan agreement, ‘specified conditions’ will naturally be a long list, especially if it includes the usual array of federal policy compliance items.  Absent other considerations, the developer will want to make sure that the list can be checked-off expeditiously and the lender undisputedly obliged to deliver the money.  In practice, this means executing the loan agreement only when project variables are settled down and construction draws are soon to be necessary.

In theory, however, a loan agreement could be executed well before any construction drawdowns were required.  The list of specified conditions might be longer and less precise, and project variables not quite so settled.  But the lender is still in effect making a ‘binding agreement’ of some sort.  A private-sector lender might use the additional conditionality to wiggle out of funding the loan, though a public-sector lending program will almost certainly be more forgiving.  Most importantly for this discussion, however, I think any kind of ‘binding agreement’ will be sufficient to trigger a loan execution for FCRA purposes – and put any further interest rate re-estimates into permanent indefinite budget authority territory.

Loan Execution-Lite

We can call this approach ‘Loan Execution-Lite’ – a loan agreement that isn’t meant to be funded in the near-future but binds the federal lender in a way that’s sufficient to trigger FCRA permanent indefinite budget authority.  For CIFIA in a rising rate environment, the point is to ‘convert’ budget-absorbing limited buydowns into worry-free executed loans.  During falling rates, CIFIA should be able to offer WIFIA-type resets and interest-rate management enhancements with confidence.

For developers, the value of execution-lite loans is added certainty with respect to interest rates, rising or falling, compared to limited buydowns.  That’s its primary purpose.  Of course, an execution-lite loan is less certain about everything else due to its expanded conditionality.  But this conditionality would need to have been worked through anyway for a typical, close-to-drawdown loan execution.  Term-sheet negotiations will continue as before, except that in legal form they’ll be about amendments to an existing agreement, not a new loan.  Nothing needs to change in the developer’s real-world actions.

A loan execution-lite agreement can be seen as a formalizing a step between loan application (with its limited buydown) and full, near-drawable loan execution (with its permanent indefinite budget authority).  In some ways, that’s more consistent with project real-world development, which is an incremental, not binary, process.

The diagram below illustrates the three-phase concept with a timeline.  The loan process will still start with an application and limited buydown, and that’s all it should be during the initial stages of development.  But once project development is sufficiently advanced for contract negotiations and finalizations to begin, an executed-lite loan agreement will be increasingly possible.  Interest rate certainty is important to the developer in this phase, and the program should want the budget treatment to support it.  The executed-lite loan agreement then gets amended to the extent necessary to be a drawable commitment shortly before construction begins.

How realistic is this execution-lite approach?  I can visualize the legal forms and I believe they’re basically consistent with the relevant FCRA statutes and published budget methodologies.  But it’s certainly new ground and, as such, prone to all sorts of negative bureaucratic interpretations, especially since the point of the exercise is to expand budget authority in a way that wasn’t explicitly described in FCRA law.  Still, WIFIA’s resets and other rate-lock enhancements relied on similar expansive interpretations, and they got through.

Naturally, CIFIA motivation is necessary, something that could surface quickly if a budget shortfall appears possible.  Otherwise, demand from borrowers for execution-lite loans will be the needed impetus.  During a period of rising rates, that’ll require a somewhat theoretical mindset from the developers, since the limited buydowns will appear to be working and the program’s budget is not their direct problem.  But if a raft of applications is made during a time of peaking rates that then consistently decline (a very possible scenario in 2022-2024), the demand for limited buydown resets could be more visceral, given the numbers involved.  WIFIA’s resets were driven by similar dynamics.  Since application resets at CIFIA will in any case require approvals and new processes, that might be the time for the program and its stakeholders to consider pushing the budget envelope a little further with an innovative approach. Sooner, of course, would be better.